The quiet power market transformation behind the new carbon market in China

In December, the Chinese government announced the launch of a national carbon emissions trading scheme (ETS), which is expected to become the largest ETS in the world. This is a major development, writes Max Dupuy, senior associate at the Regulatory Assistance Project (RAP), but its success depends on an even deeper power sector transformation that is taking place in China, which gets much less attention. This reform effort promises to completely reshape the largest power market in the world.

At the outset, the new ETS will cover only the power sector. This is a reasonable place to start. Compared to other sectors, the power sector has reasonably good data, relatively few points of emissions, and accounts for a large share of the country’s emissions.

But Chinese policymakers are also in the midst of an even more fundamental power sector reform effort that was launched in 2015 but is still a work in progress. Compared to the ETS, this power sector reform has received much less attention from observers around the world, even though it may have bigger implications for China’s emissions.

Much of the government’s hopes of meeting overarching emissions and clean energy goals will likely become tied up with this complex initiative over the next few years

It includes a sweeping initiative to design and implement another set of markets for the power sector, including new wholesale electricity markets, that promise to reshape the largest power sector in the world. The prospects for the ETS will be tied to the outcome of these deeper, ongoing power sector reform efforts. Without the power sector reform, the ETS will have difficulty cost-effectively reducing emissions.

Power sector reform

In March 2015, the State Council and the Central Committee of the Communist Party—representing the highest levels of authority in China—launched a major power sector reform push. While leaving many details to a later date, it promised to address each of the major pain points for clean energy in China’s power sector, including:

A deep restructuring of regulation of, and business models for, China’s grid companies, which are the largest utilities in the world.

An end to the traditional practice of administratively allocating an entitlement of annual hours of production to each coal generator, on a more-or-less equal basis. This approach to generator dispatch has been a chronic source of inefficiency and a major contributor to curtailment of energy from wind, solar, and hydroelectric generators.

A new structure of wholesale markets that will eventually force each generator, and eventually other resources, to earn hours of operation based on each generator’s relative operating cost.

ETS alone can’t do it

An ETS is supposed to send signals to consumers, generators, and investors about the true cost of emissions, including environmental costs. In particular, an ETS can reduce power sector emissions by adding an emission cost component to each emitting generator’s operating costs, and thereby rearranging or reinforcing the position of relatively low emission resources in the dispatch “merit order.”

The bad news is that design and implementation of markets and dispatch reform is a challenging proposition

This will tend to give cleaner resources more operating hours while also providing incentive to investors to direct capital toward low-emissions generation capacity (while investing less in high-emission capacity). However, the practice of dispatching generators according to the annual plan can seriously hamper these signals: when the system is not dispatched according to a merit order based on operating costs, this cuts off an important channel through which an ETS works to reduce power sector emissions.

Wholesale markets: progress and pitfalls

Fortunately, there is a movement toward merit order dispatch in China, in the shape of the new wholesale electricity markets. Well-designed wholesale electricity markets can serve as the basis of merit order dispatch, set the stage for greater participation of clean energy resources, and facilitate a more meaningful ETS. The idea is that generators will compete for a place in the merit order based on operational costs. And these operating costs will, in the future, include emissions costs, thanks to the ETS. This “merit order” competition is one in which existing renewable generators should do well, given their near-zero operating cost.

Building on good initial steps with market implementation, China’s national government, in September, kicked off a new calendar for rapid implementation of “spot” markets in seven provinces—a new and crucial phase in wholesale market development. These pilots are due to begin operation by 2018, with national implementation by 2020. If designed and implemented well, these markets should promote flexible operation (dispatch) of the overall system, help reduce curtailment of renewables, and send powerful signals for retirement of coal capacity.

An ongoing challenge will be to break down silos separating their spheres of responsibility

Much of the government’s hopes of meeting overarching emissions and clean energy goals will likely become tied up with this complex initiative over the next few years. The bad news is that design and implementation of markets and dispatch reform is a challenging proposition, with many potential pitfalls.

In sum, the new carbon ETS is a very welcome step forward in China, but the outlook for an effective carbon market is closely interlocked with the prospects for the new electricity markets. An ongoing challenge will be to break down silos separating their spheres of responsibility and integrate ETS implementation with the deeper power sector reform effort.